The Government's attempt to crack down on Managed Service Companies (MSCs) has been the subject of much debate and discussion - but will they actually achieve what they want - and what is it that they do want?

The introduction to the Pre Budget's Managed Service Companies' paper says: "At Budget 2006 the Government announced that it would respond to evidence of significant growth in MSC schemes which are used to avoid paying employed levels of tax and NICs."

One word in this phrase highlights a significant shift - or perhaps - a more openness by the Government as to its actual intention. For years, the Whitehall jargon has been that they need to ensure that small business pay 'the right amount of tax'. Now, they are referring to 'employed levels of tax'.

But what if the "employed levels of tax" are not the 'the right amount of tax' - at least as the current legislation stands?

IR35
Like it or loathe it - there is already an existing piece of legislation which determines whether or not you are taxed as a business or as disguised employee. This is the Intermediaries Legislation - or IR35 as it is more 'popularly' known, which has now been around since 1999.

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What the Government is now saying is, if you operate through a composite or MSC arrangement, forget IR35 - it doesn't apply to you. All the tests everyone else has to go through to determine their employment status, are wiped away for you. You are a disguised employee whether you pass or fail the tests that the rest of the country can use.

To date, these schemes have not been exempt from IR35. They have to make the decision whether the person joining the arrangement is outside IR35. No doubt there are some excellent ones and some poor ones. The 'good' ones will have in-house accountants and/or a legal department. They arrange contract reviews, they have dedicated, expert resources to ensure that the contractors who work through their schemes are 'compliant'.

In short, they are doing the Revenue's job for them.

In the case of the poor ones, who may be put people down as outside IR35, when they should be inside, there are existing measures the Revenue can use to address the non-compliance, including the Intermediaries Legislation (IR35).

So why not address the cases where the rules are being broken, rather than attack the compliant companies as well and possibly fragment and further complicate an already diverse market? Could this be not so much a case of using a sledge hammer to crack a nut; but possibly that the sledge hammer will miss - but do a fair bit of damage in the process.

Failure
The Government's preamble to the MSC report admits its inability to tackle this problem. "There are existing rules - the Intermediaries legislation - to ensure that the correct tax and NICs treatment is applied, but these rules are, in many cases, not being followed by MSCs."

The 72-page document which addresses this is effectively a signed confession that IR35 isn't working. If it doesn't work for MSCs, why should it work for anyone else? So, if it is still relevant, why not just enforce it?

The report says: "Enforcing the current rules is difficult with MSCs because of the large and growing number of workers involved and the resource-intensive nature of the legislative test."

But who introduced this resource-intensive legislative test, which has now become impossible for HMRC to police?

About six years ago, accountants and IR35 specialists, explained why IR35 wouldn't achieve what the Government intended in terms of tax raising. Regardless of the rights and wrongs of it, the common position of experts who worked with IR35 since the beginning has always been it was a bad piece of legislation in terms of clarity, certainty and enforcement.

The Government now seems to recognise that - and has with one sweep removed 100,000s of contractors from IR35's jurisdiction by imposing an over-riding set of new rules, which ignores its own legislation.

It has justified this by making a couple of assumptions:

that almost invariably the underlying nature of contracts of workers in MSCs is employment;

the worker is almost invariably not in business on his own account.

Scale of the problem
At the moment, the Revenue has all the apples - good and bad - in a small number of baskets.

Consider the current market - at the moment, by the Government's own estimates there are at least 240,000 contractors working through 150 MSC scheme providers, with around ten of these accounting for the vast majority of workers in MSCs.

It would be ridiculous to suggest that all of these are non-compliant. Some of these work closely with the Revenue to ensure they are compliant and therefore do the 'policing' of IR35 for them.

Rather than tackle non-compliant operators within that 150 figure - the Government wants to close them all and send 240,000 contractors out into a much more diverse mode of operating and possibly even more resource intensive to police.

Instead of having 150 MSC providers to deal with, the Revenue will have up to quarter of a million more individuals no longer under responsibility of a small number of providers.

What happens next
The proposals for MSCs are academic. As the new proposals stand no-one would use an MSC under these terms as they become the least effective way to operate. The intention, it seems, is not to make them easier to police, it's to kill them off.

So where will these 240,000 contractors go?

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There is little doubt that some existing providers will evolve into supporting the services of limited companies. The limited company market could divide into those who operate totally independently and those who rely on providers of some support services, while the individual retains financial and managerial control. The latter could require existing MSCs to restructure their businesses to provide support to individual companies - in some cases this should be feasible, in others the leap might not be viable either financially or within the time scale available.

But as the responsibility for the 'management and financial decisions' rests with the individual - why should the service provider bother to employ legal and accountancy departments to oversee compliance? It may no longer be their responsibility. So the good guys who ensured compliance with IR35 and provided a range of high quality advice and support, have effectively been told they don't need to have that responsibility.

There is no doubt that a number of ex-MSC users will form their own limited companies - the original target of IR35. They will then have to take on the day-to-day responsibilities for running their own companies and comply with their statutory duties and administration. This could lead to a 'blip' in the number of new companies being formed - and a busy time for Companies House. But long-time watchers of this sector will recall a similar exercise when zero rated corporation tax led to a rise in small businesses - and was later reversed as the Government accused these firms of taking advantage of the Chancellor's 'good-nature' and indulging in 'tax motivated incorporation'. (Remember IR591)

Agency PAYE may be an option for some, but is likely to increase overheads for the agency and bring employment risks which agencies might not be willing to take. There is no real opportunity to take advantage of expenses and is likely to be unsuitable for a long-term contractor.

Umbrellas are already popular with contractors caught by IR35. However, there is a two edge sword poised over the heads of umbrellas. At the moment, it is unclear if they will be affected by this legislation. And, even if they are not, the Treasury has already stated it is looking at the dispensation for expenses used by umbrellas.

Sledgehammers
In conclusion, the market will fragment and become more diverse. IR35 will apply to some, but not others. Expenses will be allowable for some, but not others. Some currently compliant companies will disappear; some non-compliant companies will go 'underground'. HMRC can't police 150 companies; but has potentially increased the companies it needs to police by a factor of possibility 1,000.

The MSC proposals are an attempt to address a perceived problem caused by the inefficiency of an attempt to address another perceived problem.

IR35 was described as a 'sledgehammer to crack a nut'. In this case the sledge hammer may miss the nut, but do a fair amount of collateral damage in the process.